Raising safety standards to protect investor interests
Asset owners and investors may require a chain of financial intermediaries, including global custodians and sub-custodians, to hold their securities and help them facilitate safekeeping and asset servicing. These assets are typically held by the custodian in an account at the issuer’s national central securities depository. But asset owners can lose access to – and control of – assets in the custody of a financial intermediary that becomes insolvent or is otherwise unable to meet its obligations to depositors or other creditors. This can happen if records and processes are not properly maintained throughout the chain, especially where the assets are held in shared (omnibus) accounts. It is hardly surprising, therefore, that safekeeping of securities has come under particular scrutiny. Rules around asset safety are being tightened in many major jurisdictions, e.g. at the European Union (EU) level, but also at national level such as in Australia and the UK. This comes in response to high-profile examples of inadequate clarity and protection for asset owners during and after the 2008 global financial crisis. Fundamentally, the rules require asset owners and managers to ensure assets are fully under their control, regardless of where they are held or the length of the custody chain. But these stricter requirements have far-reaching implications for service providers too.
Fundamentally, the rules require asset owners and managers to ensure assets are fully under their control, regardless of where they are held or the length of the custody chain. But these stricter requirements have far-reaching implications for service providers too.
The central challenge for all parties is legal certainty over the ownership of assets in event of insolvency. The collapse of Lehman Brothers in 2008 demonstrated the difficulties in identifying and returning assets to their rightful owners following liquidation of a service provider. Subsequent cases highlighted flawed segregation practices along with poor record-keeping and controls, and governance not being rigorously observed and enforced. This has resulted in the improper commingling of a client’s assets (securities and cash) with those belonging to other clients and with the service providers’ proprietary assets. Fines have been issued and rules both clarified and toughened to ensure asset owners and service providers are rigorous in the oversight of assets. Although requirements vary across jurisdictions, the overall direction urged by regulators is toward more transparency, control and segregation in the safekeeping of assets. This requires asset owners and managers undertaking reviews – and possibly upgrades – of due diligence processes in terms of selecting and maintaining service provider relationships. They may also need to revisit day-to-day operational processes, including reconciliation and reporting, to underpin and verify asset ownership and safety.
The central challenge for all parties is legal certainty over ownership of assets in event of insolvency. The collapse of Lehman Brothers in 2008 demonstrated the difficulties of identifying and returning assets to their rightful owners following liquidation of a service provider.
A global shift in the rules for segregation and safe-keeping
Major jurisdictions are continuing to tighten and clarify rules around asset safety, potentially requiring asset owners and managers and their custody service providers to review and strengthen their operational frameworks. Although service providers can be expected to provide supporting processes and information, the responsibility often starts with the asset owners and managers to comply with the rules. This post-global financial crisis tightening of asset safety requirements are part of a wider reform effort to improve efficiency, transparency and standardisation of post-trade and custody processes, including shorter settlement cycles, standardised processes and universal identifiers. Increasingly, asset safety rules have more effective extra-territorial reach, meaning their authority extends to overseas jurisdictions where assets are held on a regulated firm’s behalf. Firms must ensure all agents involved in safekeeping their assets are meeting required regulations, regardless of location. Although mature markets may be first movers in tightening rules, smaller jurisdictions already follow similar principles. Firms need to embrace the spirit of the changes being introduced and not simply the letter of the (new) laws.
The common aim is to guarantee sufficient levels of account segregation by custodians and other service providers for assets to be identified and reclaimed by their owners, effectively ring-fencing them from being used to settle creditors’ claims in the event of the financial intermediary’s bankruptcy or liquidation. At the point of engaging the custodian, this may require a legal opinion about the treatment of client assets under the prevailing insolvency laws that the custodian is subject by, and thorough due diligence regarding its service standards. On an ongoing basis, regulated firms must also ensure adequate oversight of their custody chain, including internal processes for monitoring, reconciliation, reporting, controls and dispute resolution. In Europe, regulations covering mutual and alternative investment funds – specifically the Undertakings for the Collective Investment in Transferable Securities V and the Alternative Investment Fund Managers Directive (commonly referred to as the ‘UCITS V’ and ‘AIFMD’) respectively – were amended in 2019 to establish EU-wide rules protecting client assets in the event of custodian or depositary insolvency. Service providers must now support accurate and frequent information flows and reconciliation processes to enable identification and traceability of assets held in omnibus accounts.
In the UK and the US respectively, the Financial Conduct Authority’s Client Asset Sourcebook (CASS) and Securities and Exchange Commission (SEC) Rule 17f-5 impose high standards on fund managers and custodian when it comes to oversight of client assets. The SEC rules apply specifically to assets of US firms held overseas; the CASS applies to UK-incorporated firms and non-EEA firms with UK branches and was updated in 2015 to require more detailed, frequent and automated reconciliation and reporting processes.
Amended in 2018, Australia’s RG 133 requires investment schemes and their custody providers to observe minimum standards on records, organisational structure, resources, staffing and segregation.
In the UK and the US respectively, the Financial Conduct Authority’s Client Asset Sourcebook (CASS) and Securities and Exchange Commission (SEC) Rule 17f-5 impose high standards on fund managers and custodian when it comes to oversight of client assets. The SEC rules apply specifically to assets of US firms held overseas; the CASS applies to UK-incorporated firms and non-EEA firms with UK branches, and was updated in 2015 to require more detailed, frequent and automated reconciliation and reporting processes.
Taking control means taking responsibility
Increasingly stringent asset safety rules require asset owners and managers to review how they select their custody service providers and how they interact with them on a daily basis. To ensure control and oversight of assets, regardless of where they are held globally, firms may need to improve their due diligence and operational processes.
Due diligence – Prior to engaging a custodian, asset owners and managers should establish a framework to determine their satisfaction with the level of asset segregation, transparency and control offered by the prospective service provider, perhaps including scores, metrics and periodic reviews. This may be achieved through questionnaire (e.g. Association for Financial Markets in Europe template) or site visits, in line with the firm’s risk management policies. Areas to consider may include, but are not limited to:
Ongoing oversight – To ensure effective control and oversight of assets under custody, asset owners and managers must not only monitor their service providers on a regular basis, but also their own internal processes. In particular, this requires reviewing and updating processes involved in handling and reconciling statements of holdings and transaction reports, and regularly reviewing account usage.
In testing times, can technology deliver transparency?
Asset safety and control are integral to investor confidence and therefore crucial to the functioning of financial markets. The industry is embracing efforts to remove uncertainty over investors’ ability to achieve oversight over their assets – and retrieve them in light of unforeseen circumstances on a timely basis, especially given growing sources of volatility and uncertainty. However, moves toward more robust asset safety rules are likely to accelerate consolidation among service providers and could reduce choice, especially if a market event leads to even stricter segregation standards. Custody service options have always involved trade-offs: strong protection is balanced against higher costs and lower speed of access. Increased segregation typically adds costs and makes it harder to offset these via revenues from ancillary services. With regulatory and market infrastructure changes having already increased costs over the past decade, further margin pressure could narrow the field. Technology is helping service providers to improve transparency, increase efficiency and develop more value-added services. Innovations include the Single Touch Model (“STM”) offered by Standard Chartered’s international custody hubs. Compared to the traditional model between a global custodian and its sub-custodian where each intermediary maintains its own ledger of transactions, STM enables a shared ledger between the Standard Chartered entity acting as a ‘Hub’ and its affiliated sub-custodian within the Standard Chartered network. In this way, by giving both parties access to the same central records and shared ledger, STM minimises the need for reconciliation and reduces the potential for error while also improving settlement efficiency and speed.
Safety first
Asset owners and managers are already alert to the need to protect their assets. In a volatile and unpredictable business environment, it’s particularly important that firms assert and maintain full control and ensure rigorous oversight of service providers. As such, all market participants support the efforts of regulators to increase investor protection and systemic stability. As a provider of custody services in 40 markets (and access to a wider range of markets via our network of relationships) Standard Chartered offers a consistent level of service – and safety – combined with deep local expertise. Wherever your home jurisdiction, we stand ready to support your evolving needs, up to and beyond the new requirements being set by regulators.
